The United Arab Emirates (UAE) macroeconomic performance during 2007–08 was strong, with growth especially in the construction and services sectors and despite some slowdown in the last quarter of 2008, due to the global crisis. Annual average inflation accelerated, driven by domestic demand pressures (especially rents) and higher import prices (such as prices of food, building materials and skilled and unskilled workers). Higher oil prices contributed to large external current account and fiscal surpluses in both 2007 and 2008.

However, the outlook for 2009 and beyond has become more clouded, as the UAE has been adversely affected by the turmoil in global financial markets. This is evident in a widening of sovereign risk spreads and a sharp downturn in stock markets — most pronounced for real estate companies. Large private capital inflows, driven by expectations of an appreciation of the dirham vis-à-vis the US dollar, largely reversed over the summer of 2008; currency futures indicate that markets no longer doubt the peg. Foreign financing for many corporates has tightened, and a slowdown in real estate and construction seems underway. The global weakening will reduce demand for tourism, trade, and financial services, while lower oil prices may affect public spending. Growth in the non-oil economy is expected to slow down considerably, while inflationary pressures should recede.

The UAE banking system appears adequately capitalized and highly profitable, but risks have risen. Banks’ assets and profits increased sharply in 2007 and the capital adequacy ratio stood at 13.3% by mid-2008, above the regulatory minimum of 10%, though somewhat below the level of 2007. However, the fast pace of growth of consumer and real estate loans along with the uncertain outlook for asset prices has raised the risk of a future increase in nonperforming loans (NPLs). Capital outflows, and growing concerns about counterparty risk, have in recent months affected the functioning of the interbank market.

Money and private sector credit growth accelerated further in the first nine months of 2008, and liquidity became tight in late summer. Credit to the private sector rose by 51% (year on year) in September 2008, up from 40% in December 2007, with demand driven by the economic boom and highly negative real interest rates. In mid 2008, the central bank took several steps to address a drying-up of liquidity following the outflow of foreign deposits. Subsequently, to preempt spillovers from the global turmoil, the government issued a blanket guarantee for deposits and inter-bank lending for three years, and put in place a USD19bn emergency liquidity support fund to provide banks with long-term funding.

The short and medium-term outlook is subject to a number of downside risks arising from the difficult global environment as well as domestic financial vulnerabilities in the wake of the recent real estate and credit boom (especially in Dubai). The main risks to the outlook stem from (i) a more severe global weakening; (ii) further tightening of foreign financing for investment projects; (iii) an increase in the demand for domestic financing adding to banks’ stress; (iv) a correction in the real estate market leading to a deterioration of asset quality in financial institutions; (v) a drop in oil prices that constrains the scope for fiscal policy to support growth; and (vi) an unexpected re-emergence of inflationary pressures.

The IMF issued their Executive Board Statement:

"Safeguarding the soundness and functioning of the financial sector, while facilitating a smooth and orderly deceleration in credit growth from an unsustainable pace is very important. Actions have been taken to guarantee deposits and inter-bank lending for three years, and to establish liquidity facilities. Contingency plans for a worse than expected downturn should focus on safeguarding only systemically important institutions. Going forward, the fiscal costs of assistance to the financial sector will need to be minimized, and incentives provided to prevent a buildup of risky assets."

"Directors welcomed the plans to amend the banking law to strengthen the central bank’s supervisory and regulatory power and to launch a thorough review of banks’ balance sheets, off-balance sheet items, and large exposures. They urged the authorities to improve the classification of loans in order better to assess risks, and to strengthen surveillance over bank and finance company risk management practices."

"The authorities need to maintain essential ongoing infrastructure investments to boost productive potential, while reining in commitments for new projects and rationalizing subsidies. Any financial support for corporates should aim to cushion the fallout from the drying up of foreign financing and promote adjustment to a less buoyant outlook. If the economic environment deteriorates more than expected, a more active countercyclical fiscal stance would be called for to support growth and employment. The establishment of the Federal Council to Coordinate Fiscal Policy is aimed at coordinating budgets and expenditures between the emirates and the federal level and ensuring that the UAE’s overall fiscal stance safeguards macroeconomic stability. The introduction of VAT over the next 2–3 years should make the budget less vulnerable to oil price fluctuations."

"The exchange rate peg of the dirham to the U.S. dollar remains appropriate, providing a strong and proven anchor in the stormy economic conditions that may lie ahead. The central bank assess that the real appreciation of the dirham in 2008 and the ongoing reversal of terms of trade gains with the recent drop in oil prices may have eliminated any dirham undervaluation."

"The UAE’s participation in the General Data Dissemination System is beneficial. The establishment of a National Bureau of Statistics and the dissemination of monthly CPI data in 2009 is planned. The authorities should continue to strengthen national accounts and public sector statistics. Greater transparency on public financial assets and liabilities could help shore up investor confidence."